Wednesday, September 2, 2015

Hedging Your Bets

When we were taking principles of investment finance in college (centuries ago), we learned various ways of valuing shares on the stock market.  Mostly this was because (as we were taught) the easiest way to buy a company is to purchase its shares on the secondary market.  (It’s not.  The 100% S-Corp ESOP is, under current law, the best way, but it doesn’t apply to anyone who doesn’t work in that particular company. . . .)

Anyway, the market is supposed to function to determine the real value of a company based on its past performance and future projections.  There is, however, a lot of slippage, due to factors such as insufficient information, emotionalism, and interference in the free market.

Peter Lynch
Your job as a financial analyst is, presumably, to decide if the market is right or wrong, and make a decision accordingly.  You look at the company, the product, the market, and overall economic conditions, and invest in what you know, whether in your own company, or in others.  This is the approach later popularized by Peter Lynch, author of One Up on Wall Street (1989), Beating the Street (1994), and so on.

Lynch’s approach, which stresses the importance of “local knowledge” (a more realistic “small is beautiful” system than that of E.F. Schumacher), presumes a rational market.  This, in turn, implies a free market, a sound financial system, and a uniform and stable currency.  “The Street” (Wall Street) is not, in Lynch’s system, the most important or even the most accurate gauge of the real value due to the lack of local knowledge.

By knowing more than the market, an intelligent investor can, in theory, purchase a solid company for the long haul, while a canny speculator can (again in theory) make some spectacular short-term gains through long sales.  A “long sale” is where you purchase an undervalued stock, and wait for the market to recognize the stock’s true value, whereupon you sell and realize a gain from your superior knowledge.

Interestingly, Lynch avoided the short sale approach, which is key to the success of a hedge fund.  One gets the impression he considered it a trifle shady, and counter to the attitude of a real investor or a savvy speculator.  (That’s just an impression, however.  For all we know, Lynch may think short sales the greatest thing since sliced bread.)

Unlike a traditional long sale, a short sale is when you believe a stock is overvalued and will soon go down in price.  You borrow blocks of the overvalued stock and sell it.  You then wait for the stock to drop in price, whereupon you repurchase the same number of shares you borrowed, give them back to the lender plus a rental fee, and pocket the difference.

"Profit, profit, über alles. . . ."
You can see the difference immediately.  In a long sale, the amount you can lose is limited to what you paid for the shares if you guessed wrong, but the potential profit is limited only by how high the price of the shares goes.  In a short sale, the amount you can gain is limited to the value of the shares when you borrow them, but the potential loss is limited only by how high the price of the shares goes if you guessed wrong.

Why, then, are profits so much greater on short sales than long sales?

Simple.  You need money to be able to purchase shares and hold them until the price goes up in a long sale.  You don’t need anything other than someone willing to lend you blocks of shares for a short sale.  Your only investment in a short sale is the rent or fee you pay to borrow the shares, and the transaction fees you pay to sell the shares and then buy them back.  A profit of 100% on a long sale is astoundingly good, and could take years to realize.  A profit in the tens of thousands of percent on a short sale is average, and with today's computer trading can take microseconds.

This is how hedge funds make such enormous profits.  Combining short sales with computer programs that exercise calls (buy orders) and puts (sell orders) in microseconds, a tiny cash investment can be multiplied by hundreds of thousands times the actual cash required to initiate the transaction.

Snickering all the way to the bank.
For example, a hedge fund borrows a million shares of X corporation at $100 per share, for which it pays $1,000 fee.  It then sells (puts) the shares for $100 million and another $1,000 fee, ending up with net cash of $99,998,000.  The stock starts to move up, but the hedge fund has programmed the transaction to purchase (call) the moment the shares increase by, say, a tenth of a cent.  The fund cuts its losses and repurchases (calls) the shares for $100.001 per share and a $1,000 transaction fee, and returns the shares.  Total loss to the hedge fund: $103,000.  Peanuts in this game.

Now take that same million shares at $100 per share borrowed and put for a net of $99,998,000.  Instead of rising, however, the stock starts to drop.  It goes down to $99 per share in less than a minute, and then recovers and even increases to $110 per share in another minute.  Did the hedge fund lose in excess of $10 million in two minutes?

No way.  The hedge fund operators programmed their computer to call shares the moment the decline stopped and the share price started to go up.  They didn’t call at $110, but at $99.001 per share.  Instead of losing more than $10 million on that short sale, the hedge fund made $996,000 in one minute.

Now multiply that by the number of times the shares go up and down that day, and assume that the hedge fund borrows and puts the shares every time the price drops by 0.1¢, and calls and returns the shares every time the price stops dropping and increases by 0.1¢.  Even if the price remains relatively stable and fluctuates only a dollar or two all day long, and even if it only guesses correctly half the time (not likely if it only buys after the shares have already declined by 0.1¢), the same blocks of shares could be traded hundreds of times a day.

Not "Big Business", but Big Money.
This is very crude, of course.  A computer program can be written so that a minor fluctuation of a price that does not take it back up to within 0.1¢ of the initial price will not trigger a call unless the decline has been sufficient to garner a certain profit, and so on.  A program that is sufficiently sophisticated can ensure that a hedge fund always wins, whether the market for a share is going up or down.

For example, let’s go with the above assumptions, but also assume the shares are traded a hundred times in one day, the stock declines by $1 each time, and gains by $10, and the hedge fund only guesses correctly half the time.  At the end of the day, the hedge fund has made $44,650,000 by short selling a stock that is increasing in value!  Increase the drop to $2 per share each time, and the profits double, $4 and they quadruple, and so on.

Thus, on shares that end the day at the same price at which trading opened, $100 per share, a hedge fund could make in profits many times what the shares are worth!  On a wild trading day such as Wall Street has been experiencing with increasing frequency, a hedge fund can make billions of dollars in profits while risking virtually nothing.

And you wonder why no one on Wall Street is too concerned about the fact that banks aren’t lending to businesses that produce marketable goods and services that real people use?  Why should they?  They make much more money creating money and siphoning their existing reserves into the stock market to gamble.


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